Certifications

July 26, 2006

Discounting and "Baking in"

This note is important to understand what is going on with the current earnings reports and the market reaction. Read to the end for a nice illustration, even if the concept is one familiar to you.

The market is, of course, forward looking. Everyone with money at stake is attempting to make predictions about the course of prices, while using a variety of different tools.

Sometimes these predictions involve specific events. If the outcome of an event is widely expected, the stock price movement may seem (to the unsophisticated observer) to be very surprising. When a company delivers a great earnings report, but then the stock declines, analysts nod wisely and say that the earnings had been completely expected.

There are a lot of terms for this behavior including the following:

Buy the rumor and sell the news.

Buy on the cannons and sell on the trumpets (a very old one, getting recent play).

The earnings and been "discounted" in advance. (This is the best technical term, meaning that the impact was "factored in" through modeling or accounting for future cash flows. It is ambiguous for non-professionals, since there is a sense of the word "discount" that means exactly the opposite).

The information was "baked in" the stock price. (I personally dislike this one and it is already over-used, but I guess it captures the meaning.

My favorite illustration of this occurred the morning of the Iraq war. After an evening display of "shock and awe" U.S. troops had met little resistance as they raced into Bagdahd. Apparently friendly citizens flooded the streets and began tearing down various Saddam Hussein pictures and the like. The stock market opened with a nice rally, and moved higher as those who had stayed out of the market now felt it was safe to make some buys. The Iraqi's were working on a statue of Saddam, trying to pull it down. They did not have the right tools for this large statue, and it was going to take some time. It was rather fascinating to watch, so CNBC stayed right there and Mark Haines extended his hours to keep covering this event.

It was pretty obvious that the statue would eventually go down. And when it did ......the market sold off. Whether or not the statue fell had little to do with U.S. equity prices, but that is how it traded.